Let's talk about the asset section of the balance sheet. Again assets are resources that are expected to provide future economic benefit. So when can a company record assets in its books? The item has to meet two criteria to be recordable as an asset in the books. First it must be owned or controlled by the company as a result of a past exchange or transaction. And then second it has to be expected to provide future benefits that can be reasonably or reliably measured. Assets can be classified on the balance sheet as either current or noncurrent. And whether they're current or non-current depends on how quickly we would expect the company to turn them into cash, or to use them up in the operations of the business. An asset that is current we would expect to be, generally speaking, something we would turn into cash within a year, or use in the operations of the company within a year. And those that are non-current would be all those other assets that we would expect to use in the business's operations, or not turn into cash for substantially longer than a years' time. Some common examples of assets are cash, that's a really great asset to have. I think we all would probably like to have a lot of cash. Accounts receivable is another asset we typically see on companies' books. Accounts receivable is the amount that a company is owed by its customers that has not yet been paid. Inventory is another example. That's the product that a company has that it expects to sell to customers in the future. Another example, prepaid expenses. Prepaid expenses capture the amount that a company has paid to a supplier in advance of receiving a service. For example, it might pay rent in advance, a year's worth of rent in advance before occupying a building. Investments would be another example of an asset. Property, plant and equipment. That's the sophisticated accounting term for land, buildings, machinery, things of that nature. And then intangible assets. Intangible assets are those that really don't have that much physical substance in nature. We can't really touch them but they're very important resources to the firm. Examples would include patents or brand names or things of that nature. Here are some examples. Let's talk about whether they can be recorded as assets in the company's books. First example, LL Wholesale buys products costing $3000 in December. It will eventually sell those products to customers. This is something that's owned and controlled by the company as a result of a past exchange or transaction. The company bought them from a supplier. They're expected to provide future economic benefit, which will be the second criteria, because the company will sell them to customers at a profit. So yes, this can be recorded as an asset. It will be recorded on the balance sheet in the inventory account at the cost of $3000. Second example. In November, the same company delivers products priced at a total of $5,000 to a customer who will pay for them later, in February. Can this be recorded an as asset? Yes, this can be recorded as an asset. It's something owned or controlled by the company as a result of a past exchange or transaction. What is owned or controlled by the company in this situation? The right to collect $5,000 from the customer. It will provide future economic benefit, because it will eventually turn into cash. Third example. LL Wholesale signs a contract with a local company to deliver products priced at $10,000 next February. Can this be recorded as an asset in the books? No, it cannot be recorded as an asset in the books. Why not? Why can a contract not be recorded, like this, not be recorded as an asset In the books. Here there is nothing owned or controlled by the company as a result of a past exchange or transaction. No exchange or transaction has taken place yet. The company will not be able to record an asset until it delivers the products in February or until the customer pays cash for $10,000 if it were to pay cash in advance of receiving those products. Example 4, in December, the same company paid $9,000 in rent for the months of December, January and February. Can this be recorded as an asset in the books? Yes, this can be recorded as an asset in the books. There is something owned and controlled by the company as a result of a past exchange or transaction. The exchange or transaction that took place was the LL Wholesale paid the landlord $9,000. What's owned or controlled, the right to occupy the property for December, January, and February. Next example, example five. In January, LL Wholesale bought a piece of land for $25,000. In December at the end of that year, the real estate agent in the building next door says, good news, the land is worth $30,000. Well, that is good news indeed, right? So when LL Wholesale bought the piece of land for $25,000, it can put that on the balance sheet. It can record that on the balance sheet as an asset. The land was obtained in a past exchange or transaction and it's expected to provide future economic benefit because it will be used for the company in its operations to generate future revenues. So yes the land sits on the company's books as an asset at $25,000. Now what about this good news that the land is worth $30,000. Well again, indeed it is good news, but the value of the land on the balance sheet must remain at $25,000. We call that its historical, Cost. One can envision several ways that an assets value can be measured. One is its original cost or its historical cost, another might be its market value or fair value. Another might be its replacement cost, how much it would cost to replace it. Historical cost is generally the prefered measurement alternative for assets under US GAAP. Historical cost again is the original cost of the asset. So the asset will remain on the books at $25,000 and its value will not be increased to $30,000 on the balance sheet. Here's some intuition about why the standard setters for US GAAP may have made this decision Suppose I show you an office building in New York City that's owned by a very large bank. And suppose I show that same office building to about 1,000 of you. And I ask you to send me some information, about how much you think that office building is worth. How many estimates of value do you think I would get from a thousand of you trying to estimate the value of that office building? I bet you said 1,000, because that's exactly right. I would get 1,000 estimates, unless it was some coincidence, and two or more of you just happened to pick the same number. And those estimates probably wouldn't be very close around one point, they'd probably have a very wide distribution. So we can think of this as around the notion of reliability. Reliability is another one of these guiding principles that the standard setters rely on. The standard setters strive to set standards that yield financial statements with estimates that are relevant to the financial statement user and reliable to the financial statement user. So I'll add another term, relevance. So standard setters strive for relevance and reliability. Would it be relevant to the financial statement reader to know that LL Wholesales' land is worth $30,000? Absolutely. But hopefully I just convinced you that it would be very difficult to get a reliable estimate of that value. So the standard setters in the US have traded off relevance in favor of reliability. And in situations where the value of assets increase, they say let's stick to the reliable historical cost number that we know is an extremely good number because that's what the company paid for the land to start with. Historical cost, relevance, and reliability, extremely important. Now, what if I had told you that in December, the real estate agent in the building next door said, you might want to look into this land because it's not worth $30,000. We've had a real real estate crisis. And the real estate agent says, I think the value of that thing is probably down around $10,000 and the market itself is not expected to return for a very very very long time, perhaps decades. Then the management of LL wholesale would have to reflect on this estimate. They might see that this value decreased from 25000 to 10000, is what they would call a permanent decline. A decline in value that's really not expected to return for any foreseeable future. In that situation, an additional guiding principle becomes important. Conservatism So in this situation the standard setters in the US would say we need to now fall back on the principle of conservatism and reduce the value of that asset on the balance sheet to $10,000 because we see it has a permanent decline in it's value. So in summary, in the U.S., generally we do not write the value of assets up on the balance sheet. But if we see an asset that' has had what we would call a permanent decline, we would write it down on the balance sheet. We would decrease the value on the balance sheet. All of this is a result of four principles, historical cost, reliability, relevance, and conservatism, and how the standard setters have traded those off in setting the rules. It's important to mention that this is the way we do things under US GAAP for most assets. There are a couple exceptions that are beyond the scope of this example here. But for the most part we are going to leave assets on the books at historical cost, write them down for permanent declined, not write them up for increases in value. Okay, that was a lot, let's go to the next one. Example 6, LL Wholesale, the independent accountant of LL Wholesale suggests that the company's brand name is worth $1 million. That is awesome. LL Wholesale started itself, it grew itself, the brand name has increased in value to be worth more than $1 million. The company's management couldn't be happier. Unfortunately, the company's management will not record that asset on the balance sheet. Why not? Because, is a brand name something that it owns? Absolutely. Is it owned or controlled as a result of a past exchange or transaction? No. So, here we have another issue of relevance Being traded off with reliability. The standard setters are very concerned that it's difficult to get a reliable estimate of that brand name. Even though it might be relevant to know what it is, very difficult to get a reliable estimate. So the internally generated brand name that LL Wholesale has would not be recorded as an asset on a balance sheet. Now incidentally, here's a nice little tidbit of information. If another company were to buy LL Wholesaler and its view was one of the assets it was buying was its brand name, and it made the decision to pay a certain amount for all the assets plus another million dollars for the brand name of LL Wholesaler, then that acquiring company could put the LL Wholesale's brand name on its balance sheet because it would then own or control that brand name as a result of a past transaction buying it from LL Wholesale. And so that arm's length transaction would establish what the standard setters would consider to be a reliable estimate of the value of the LL Wholesale brand name. So tricky, tricky, tricky, but again the relevance and reliability principles become very important in determining whether some of these things can be recorded as assets.
